The imminent closure of a tax loophole driving the so-called “dividend arbitrage” business in European equities will cut off a major source of ancillary revenues for the region’s ETF issuers, says Josh Galper, managing principal of Finadium LLC, a consulting firm.

Dividend tax arbitrage—moving equity holdings between different jurisdictions, often via securities lending or derivatives transactions, to capitalise on the different tax treatment of dividends in different countries—is a business worth up to €500 billion a year, estimates Finadium. This sum is earned by institutions involved in the tax arbitrage business and is effectively lost to national treasuries.

Dividend arbitrage also constitutes around 40-45% of the securities lending revenues of large equity portfolios, including UCITS funds and ETFs, estimates Finadium.

Most of that $500B is not passed on to fund or ETF holders, so the impact on end investors should be small. The impact on the profitability of asset managers is another matter…

A man wearing fourteenth century armour walking across a muddy field won’t travel particularly quickly. Put him in a crowd with longbows firing at him, and he is likely to have a very bad day. The Hundred Years war, from Crécy to Agincourt, showed that that expensive creation the armoured knight was no longer the cutting edge of warfare. The longbow was the crucial piece of technology that rendered him obsolete.

This all comes to mind reading a great piece of Citibank research on the profitability of the big investment banks. Basel 2.5 was the beginning of the end – FICC’s Crécy – and Basel 3 was the definitive engagement – FICC’s Agincourt. As Citi says:

Assuming a full capital allocation on Basel 3, we estimate fixed income trading ROEs in 2011 were in the mid-single digits

…Which would correspond to 13-14% ROE in a “normal” macro environment and no impact from regulatory headwinds…

…But falls to 10-12% when we factor in our estimated impact to revenue pool from regulatory reform, although there will be a wide disparity.

In my view, FICC with an ROE close to the banks' cost of capital makes little sense. (Citi disagrees, quoting synergies with other higher return businesses such as investment banking.) Much of this activity is already moving to hedge funds, and this trend will continue unless ROEs improve - which they won't, thanks to Basel 3. It will take a long time for the edifice of large bank-based trading operations to be deconstructed, just as it took over a hundred years for the mounted knight to be replaced by lighter, faster moving troops. There will be be a few survivors: Citi suggests JPM, DB and BARC will be among them, and I don't disagree. The trend is clear though: in the long term, large and profitable FICC operations will become about as rare as the cuirass in global banks.

Perhaps tediously, I want to go back to the size of JPMorgan’s surplus liquidity. Bloomberg has some new data:

About half of the $381.7 billion in JPMorgan’s chief investment office portfolio is in company bonds, asset-backed securities and mortgage debt not backed by the U.S. government, according to a March 31 filing. That compares with 7.7 percent at the end of 2007. The amount, $188.1 billion, is more than the holdings of such securities by its three biggest competitors combined. It exceeds the total assets of Atlanta-based SunTrust Banks Inc., the 10th-biggest U.S. lender.

Now look at JPM’s CIO. They are a thousand times bigger than the ideal size. Simply finding a reasonably safe home for that $400B is quite difficult. Making a meaningful change to asset allocation is very difficult. This isn’t expiation for the losses – just another sign that JPM, along with its peers, is too big.

1. Eurozone fears are overdone. Many market participants are in my view overestimating the likelihood of Eurozone breakup, especially in the short to medium term. Long the Spain/Germany spread.

Result. It made money on an accrual basis, but the P/L volatility on a mark to market basis was ugly. Score 1/2.

2. The developed equity markets are overbought. They are likely to continue that way for some time, so I like selling 3 or 4 year slightly out of the money calls on the Eurostoxx and SPX.

Result. The Eurostoxx trade, the SPX one (so far) didn’t. Score 1/2.

3. Japan might finally get its act together. OK, perhaps not that likely, but a medium sized punt on the Nikkei feels like reasonable value. Expect yen appreciation, though, so you might want to currency-protect that.

Result. Underwater, but not by too much. Score 1/2 mainly for calling the currency right.

4. Liquidity becomes better priced. Basel will force banks to consider security liquidity more carefully, and thus liquidity premiums will increase. Hang on to assets with great liquidity characterisistics for now, and look to bleed them out via two way total return swap structures or similar as the banks get more desperate.

Result. Hard to assess but certainly not wrong. Score 1.

5. Sovereign CDS basis to increase on the best quality countries. The trend in the previous point will make govies more attractive while CVA hedging will increase the demand for CDS. This will cause the CDS/bond basis to increase. Consider the negative basis trade on govies.

Result. That worked. Score 1.

3 1/2 out of 5. Not too bad. I’ll let you know where to leave the 2 and 20.

The FT (sorry, locating the link on the site is beyond me) has an interesting story in today’s funds management section on benchmarks. Basically the thesis is that cap weighted indices inflate the share of dubious companies in bubbles and hence encourage investors to buy into the boom, and a contribution-to-GDP weighted index avoids these problems. Certainly the ‘disasters that you would have not have been drawn into’ list is persuasive. But the downside of course is that if the next big thing really does become, well, a big thing, you buy into it too late. For a bond index that isn’t too bad but for an equity index it might be terrible. I wonder if one year forward P/Es are any better. They are more volatile that ten year historic GDP contributions of course, but they might offer a reasonable alternative. Certainly thinking hard about how your benchmark behaves in bubbles, in genuine growth spurts, and in depressions is a sensible idea.

There has been quite a bit of talk recently about the high levels of correlations between returns both within asset classes and between them. See for instance here for the FT or here for Bloomberg.

The causes of this higher level of correlation are clear. Increased trading of indices and index-based products such as many ETFs results in underlyings being bought or sold together rather than idiosyncratically. Another driver is increased cross asset trading, particularly from hedge funds. There are good macroeconomic reasons for increased correlation too, notably globalisation.

While the increase in correlation is easy to understand, it causes problems. First and most importantly it means that diversification of investment works less well (as Pimco discuss here). Second, there are various structured products, notably in equity derivatives, that leave the issuing bank short correlation. If correlation increases, they lose money. This phenomena — a product that makes a lot of money but which leaves a difficult-to-hedge risk position — is well-known in equity derivatives. Guaranteed equity bonds (basically bond plus call structures) left banks short volatility in the 90s; they solved the problem by inventing a new product to buy vol back, the volatility swap. It is not surprising, then, that they same trick has been used recently with correlation. Banks have approached hedge funds to buy back their correlation exposure (as discussed by Risk here).

The problem is this position has not been good for the sellers. At least with volatility the case for mean reversion is clear. Sell S&P index vol at 20, and you might get hurt for a year or even two, but over a five year swap you are very likely to make money, even if the period includes a crisis. Sell S&P correlation at 60 (a level that would have seemed very generous before the crisis), and it is not clear that things will go as well. There is some level of correlation which is a good sell, but it is not clear that we are there yet. Call me when we’re at 95, and I’ll see what I can do…

Naked Capitalism quote an article by Pimco’s global strategic adviser Richard Clarida and CEO Mohamed El-Erian in the FT. They point out that the expectations of future economic conditions are much wider than normal. From here they make two leaps, neither foolish but leaps nevertheless.

They assume that not only are expectations more volatile, but they are fatter tailed. In other words, a normal distribution is a less good model. This may well be true, but Clarida and El-Erian don’t present any evidence for it.

They also assume – and this is a bigger leap – that this means that actual returns will be fatter tailed. Now this seems intuitively plausible, given the degree of economic uncertainty at the moment, but it is an assumption. We could be on the edge of a low-volatility high-growth phase: this is unlikely, perhaps, but it is possible.

Let’s run with it, though, and assume the Pimco guys are right. They suggest five implications:

First, investing based on “mean reversion” will be less compelling. Even though flatter distributions with fatter tails have means, the constituency for mean reversion investing will shrink as those means will be much less often realised in practice. A world where the realised return rarely equals the expected valuation creates a bigger demand for liquid, default-free assets; it also lowers the demand for more volatile asset classes such as equities. These shifts are already taking place.

This makes sense. The problem is there just aren’t enough safe assets, and attempts to manufacture them by the private sector have proved catastrophic. One very useful thing that governments could do is to increase the supply of very low risk bonds. World Bank issued twenty and thirty year linkers in GBP, EUR, USD, CHF and JPY anyone?

Second, frequent “risk on/risk off” fluctuations in investors’ sentiment are here to stay. Investors, based on 25 years of rules of thumb that “worked” during the great moderation, thought they knew more about the distribution of risk than they in fact did.

Third, tail hedging will become more important. An understandable consequence of the crisis is less trust in diversification as the sole mitigator for portfolio risk. We are already seeing increased investor interest in tail hedging, though the phenomenon is still limited to a small set of investors.

The problem is tail hedging is really difficult, as counterparty risk is a big issue in the tail. Finding the right hedge is hard enough: finding a counterparty willing to sell it to you who is sure to be around in a tail event is even more difficult.

Fourth, historical benchmarks and correlations will be challenged. In this new “unusually uncertain” world, many investors will need to fundamentally rethink the design of benchmarks and the role of asset class correlations in implementing their investment strategies. The investment industry is yet to give sufficient attention to this.

That is very true: many investors are still comfortable with correlation-based models that simply don’t work very well. Diversification is getting harder to get, and conventional wisdom about balanced portfolios is increasingly out of date.

Finally, less credit will be available to sustain leverage and high valuations. Even apart from the inevitable response to regulatory actions aimed at derisking banks, a world of flatter and fatter distributions will reduce available supply of leverage to finance trades and balance sheet expansion.

I was chatting to someone from a major investment bank yesterday about prime brokerage. Our conclusion was that it is not clear that this business makes sense at the moment, because the returns from providing leverage are simply not high enough. If we are right, then leverage costs are going to rise for hedge funds. This is certainly part of the trend Clarida and El-Erian identify. Low leverage, long tail protection, and skeptical about diversification: this is the new normal in investment management.

Corporate bonds are a better bet than most government bonds. Would you rather have your money in Vodafone Group Plc, with millions of customers paying their mobile-phone bills every month? Or in U.K. government bonds, with a weak economy, a massive welfare bill and a budget deficit equal to more than 10 percent of gross domestic product?

Small companies are safer than blue chips. Just think of the problems that BP Plc has run into in the past few months. Giant enterprises can run into giant trouble. The smaller businesses can flourish under the radar.

Private-equity and hedge funds beat bank deposits. It was the banks that ran into trouble in the credit crunch, not the alternative-investment industry.

We don’t know precisely what will emerge as “safe” once the dust has settled on both the credit crunch and the sovereign-debt crisis. But emerging markets are safer than developed ones, equities beat property, and corporate bonds are preferable to government notes.

Now, some of those examples are foolish. But the broader idea that what is safe is changing is reasonable. The conventional wisdom will have to be updated.

Robert Litterman is head of quantitative resources at Goldman Sachs Asset Management… And as he sees it, … quantitative hedge funds have to do a better job of making money for their clients. And in Litterman’s considered opinion, they need to find new ways of making money. New and non-quantitative, apparently.

We’re putting together data that’s not machine-readable.

I see. Any other pearls of wisdom?

You have to adapt your process. What we’re going to have to do to be successful is to be more dynamic and more opportunistic.

Totally worth the price of admission to the Quant Invest 2009 conference (flight to Paris not included). Thank you, Bob.

Now that is quite amusing, but perhaps a little unfair. What is clear is that you can make money for extended periods of time by being long liquidity premiums and short volatility. Many hedge fund ‘strategies’ are just versions of this strategy: get exposure to illiquid assets, leverage up, and hope there is not a flight to quality before you have got paid your 2 and 20. If you can guarantee your leverage through good times and bad (or are not leveraged at all and can lock investors in for long enough), this strategy is often successful even through a crisis. But if you have to sell into the storm, things will go rather less well.

One thing that might be interesting, then, is somehow measure alpha relative to probability of having to deleverage. That is, we ought to level the playing field between funds that generate high alpha at the expense of running the risk of having to sell into a crisis and those funds which generate less excess return, but which never have to deleverage.

*OK, some of you might not remember Blockbuster. It was a classic, in the sense of classically, heroically awful.

Hedge funds started this crisis in the doghouse. Yet they are the dog that has not barked. Their industrial structure may explain why. Unlike banking, the hedge fund sector does not comprise a small number of large players, but rather a large number of relatively small players. The largest hedge funds typically have assets under management of less than $40bn, the largest banks assets in excess of $3 trillion.

Unlike banking, concentration in the hedge fund sector is low and has been falling. The top 5 hedge funds comprise around 8% of total assets, down from 30% a decade ago. Unlike banking, the business models of hedge funds are typically specialised rather than diversified…

It may be coincidence that the structure of the hedge fund sector emerged in the absence of state regulation and state support. It may be coincidence that the majority of hedge funds operate as partnerships with unlimited liability. It may be coincidence that, despite their moniker of “highly-leveraged institutions”, most hedge funds today operate with leverage less than a tenth that of the largest global banks. Or perhaps it might be that the structure of this sector delivered greater systemic robustness than could be achieved through prudential regulation. If so, that is an important lesson for other parts of the financial system.

The point is excellent. While there have been hedge fund losses during the crunch, the hedgies have not endangered financial stability to anything like the extent that regulated financial institutions have. This could well be because they are diversified in their risk taking, relatively small, and typically not highly leveraged. It is clear that 10,000 small, diverse, low leverage firms form a much more stable financial system than 10 huge, similar, highly leveraged ones.

FT alphaville suggests hugging a hedgie. I beg to disagree with most of their reasons. Let’s go one by one.

1) They provide liquidity. More liquidity equals less market volatility.

Nope. The hedgies are often close to one way. They provide liquidity when we don’t need it, as bubbles inflate, but they all rush for the exit when the bubble bursts, making the fall worse and exascerbating downside illiquidity.

2) They help burst bubbles. Short selling is as popular as a cold sore under the mistletoe. But who can now say the shorts were wrong about the banks?

Case unproven. Some funds were short; others were long. Shorting is a good thing, but the hedgies are not necessary for it to persist as a mechanism for enhancing market discipline.

3) They help restore confidence. It’s hard to invest when credit is in short supply, but hedge funds naturally play host to the kind of inspired risk-takers who will spot likely gems in the rubble and pull them – and us – out of the downturn.

Possibly true, but their business model relies on leverage, and that is in short supply. There is no reason non hedgie investors cannot play the same role.

4) They innovate. Innovation is a dirty word. Combined with excessive leverage, it has proved a dangerous concept, but properly applied, it will provide creative fuel for recovery.

Nonsense. Most product development is done in banks. Hedge funds are typically too small and too profit focussed to innovate. I can’t think of a single product they invented rather than simply bought.

5) The survivors will be better people.

So clearly nonsense I won’t dignify it with any further comment.

6) The survivors will cost less to employ. The industry’s mid-2007 fee structure looks as outdated as a 1929-vintage stock ticker machine.

That’s like saying a Bentley at £200K is a bargain because it used to be 300. It’s still a very expensive way of getting about, and damaging to the environment to boot. Talking of boots, how about kicking hedgies? It could be more fun than hugging them.

7) They help prop up the economy. Do you really want to witch-hunt all that wealth out of Mayfair?

Err, do I have to answer that? But the concept of stalking Mayfair with a matched pair of Purdey’s taking out Porsche drivers is quite attractive for, say, a video game…

Seriously, though, I’m not anti-hedgie. But I do think that their leverage is dangerous and that the one way nature of their liquidity provision is not helpful to financial stability.

FT alphaville comments on convertible bond arbitrage (in connection with VW, but that need not detain us here). A few points. First the article says CB arb had sizzled out post-2005 due to lack of issuance. Is that really true? I always thought it had sizzled out because CBs were more fairly priced, so it was no longer obvious that buying vol via the CB and delta hedging was a good idea.

Secondly, there was a surge in CB issuance earlier this year: financial companies sold more than $35bn of convertible bonds in the first nine months of 2008. A lot of this paper was presumably gobbled up by hedge funds keen to get back into the play. And for a while it went well. As the FT reported back in 2007:

Convertible arb has returned from the dead. Two years after investors abandoned one of the pillars of the traditional hedge fund portfolio, convertible bond arbitrage is once again attracting interest – and billions of dollars of new money.

Hedge funds specialising in convertible bonds produced their best performance since 2000 last year, returning as much as the previous three years combined.

Classic CB arb players are long the CB, short stock. This is a long vol position: rising vols should make money. Perhaps some of them were hurt by short selling bans or increased stock borrow costs, but that explanation not seem to explain the scale of the losses.

Clearly leverage is more expensive and harder to come by. Advanced CB arb players bought CB options (the right to call the CB on an asset swap basis), though, and that is term leverage. You can’t easily repo CBs (can you?) so repo squeeze isn’t an issue. Again I don’t see quite how this factor would impact CB arb specifically.

Credit spreads have gone out, and that will have hurt those funds with naked credit longs, but many funds bought CDS protection on the credit, so again the size of the move is surprising.

What is working for hedge funds in the current climate? Bloomberg has a discussion of what isn’t:

Hedge-fund titans James Simons and Stephen Mandel are showing the biggest losses of their careers in the $1.9 trillion industry’s worst start in more than a decade.

Simons’s $18 billion Renaissance Institutional Equities Fund declined 12 percent since its value peaked last May, investors with direct knowledge of the situation said. Mandel’s Lone Cedar Fund dropped about 10.6 percent from its high in December, according to people familiar with the fund.

What is interesting is that Simons and Mandel are very different kinds of manager: Simons is a quant whereas Mandel is an old-fashioned stock picker, albeit a highly respected one. Just to add colour, elsewhere there has been some discussion of hedge fund attrition and the evolution of models in quant funds. Where does this leave us?

Model risk has always been with us but with gapping markets, expensive funding, a renewed focus on counterparty risk, and a flight to quality now is not the time to be highly leveraged or to rely on any strategy which assumes short- or medium-term mean reversion. History, for a while at least, will not be repeating itself.

Your leverage should be calibrated on the assumption that asset prices can jump without you being able to trade, then your leverage provider will make a fundamentally wrong but just about justifiable margin call based on the most conservative mark to market they can come up with.

There is good money to be made in picking up fundamentally solid companies cheaply but again you can lose money in the short term so having enough capital and patience to wait it out is key. Do as Warren did and buy solid forward earnings for cash.

Remember that even if a model backtests well the very act of using it in any size changes the market dynamics. And the chances are that even if you aren’t using it in size someone else will be: see for instance Have we quants been brainwashed by Barrahere.

Keeping your leverage low is important, but so is reducing both ordinary and alternative beta. There are a number of funds who are close to the edge at the moment, at least if we believe this source. Personally I prefer a more glib but funnier source here. But in any event, ensure the portfolio is well hedged until the chaos has subsided and bear in mind that there will be more bodies on the slab before this is over.